Question

HEALTHY OPTIONS INC.

Healthy Options is a Pharmaceutical Company which is considering investing in a new production line of portable electrocardiogram (ECG) machines for its clients who suffer from cardiovascular diseases. The company has to invest in equipment which costs $2,500,000 and falls within a MARCS depreciation of 5 years, and is expected to have a scrap value of $200,000 at the end of the project. Other than the equipment, the company needs to increase its cash and cash equivalents by $100,000, increase the level of inventory by $30,000, increase accounts receivable by $250,000 and increase accounts payable by $50,000 at the beginning of the project. Healthy Options expects the project to have a life of five years. The company would have to pay for transportation and installation of the equipment which has an invoice price of $450,000.

The company has already invested $75,000 in Research and Development and therefore expects a positive impact on the demand for the new product line. Expected annual sales for the ECG machines in years one to three are $1,200,000, and $850,000 in the following two years. The variable costs of production are projected to be $267,000 per year in years one to three and $375,000 in years four and five. Fixed overhead is $180,000 per year over the life of the project.

The introduction of the new line of portable ECG machines will cause a net decrease of $50,000 in profit contribution after taxes, due to a decrease in sales of the other lines of tester machines produced by the company. By investing in the new product line Healthy Options would have to use a packaging machine which the company already has and which will be sold at the end of the project for $350,000 after-tax in the equipment market.

The company’s financial analyst has advised Healthy Options to use the weighted average cost of capital as the appropriate discount rate to evaluate the project. Information about the company’s sources of financing is provided below:

• The company will contract a new loan in the sum of $2,000,000 that is secured by machinery and the loan has an interest rate of 6 percent. Healthy Options has also issued 4,000 new bond issues with an 8 percent coupon, paid semiannually, and which matures in 10 years. The bonds were sold at par, and incurred floatation cost of 2 percent per issue.

• The company’s preferred stock pays an annual dividend of 4.5 percent and is currently selling for $60, and there are 100,000 shares outstanding.

• There are 300,000 thousand shares of common stock outstanding, and they are currently selling for $21 each. The beta on these shares is 0.95.

Other relevant information about the company follows:

The 20-year Treasury Bond rate is currently 4.5 percent and you have estimated market-risk premium to be 6.75 percent using the returns on stocks and Treasury Bonds from 2010 to 2019. Healthy Options has a marginal tax rate of 25 percent.

As a recent graduate of the UWIOC, The General Manager of the company has hired you to work alongside the Financial Controller of the company to help determine whether the company should invest in the new product line. He has provided you with the following questions to guide you in your assessment of the project and to present your findings to the Company.

REQUIRED:

7. Determine the weighted average cost of capital (WACC) for Healthy Options.

8. Calculate the initial investment cash-flows.

9. Calculate the after-tax operating cash-flows.

10. Determine the tax on salvage value of the equipment, then show the terminal year cash-flows.

11. Identify three (3) relevant cash flows which were mentioned in the case and how they should be treated in the capital budgeting decision.

12. Taking into consideration all the information given, determine the Net Present Value of the project and advise the company on whether to invest in the new line of product.

(Use your answer to Q7 rounded to the nearest whole in the calculations of the other questions where necessary.)

Answer 1

1.The weighted average cost of capital

a.cost of equity(under CAPM) =RF+beta(market risk premium)

Rf =4.5%

Market premium =6.75%

beta =.95

Ke =4.5+.95(6.75)

=10.9125%

b.cost of debt

loan =6%(1-t)

=4.5%

Bond =I+(RV-NP/N)/((RV+NP)/2)

I = (4000*100)*(8%/2) =16000

=(16000+(400000-(400000*.98)/10)/(400000+392000)/2

=16800/396000 = 4.24%

c.preferred stock =4.5%

Source	Amount	weight	cost	WACC
Equity(300000*21)	6300000	.4286	10.9125%	4.667
Preferred stock(100000*60)	6000000	.4082	4.5%	1.8369
Bond (4000*100)	400000	..03	4.24%	.1272
Loan	2000000	.136	4.5%	.612
Total	14700000			7.2431%

  

2.initial investment cash flow

Cost	amount
cost of machine	2500000
Add;Networking capital(100000+30000+250000-50000)	330000
Transport and installation	450000
Research and development	75000
Total	3355000

3.After-tax operating cash flow and NPV calculation

Particulars	Year 1	Year 2	Year 3	year4	Year 5
Revenue	1200000	1200000	1200000	1700000	1700000
Variable cost	267000	267000	267000	750000	750000
Fixed cost	180000	180000	180000	360000	360000
Less;deprecition(underMACRS	500000	800000	480000	288000	288000
Cash flow before tax	253000	-47000	273000	302000	302000
Tax @25%	63250	-11750	68250	75500	75500
Cash flow after tax	189750	-35250	204750	226500	226500
Cash flow after depreciation added back and sale value of machine	689750	764750	684750	514500	664500
DF @7.24%	0.932	0.869	0.811	0.756	0.705
Discounted cash flow	642847	664567.75	555332.3	388962	468472.5
Total DCF	2720181.5
Initial outflow	3355000
NPV	-634818.5

Conclusion

Since NPV is negative it is better to reject the offer

Tax on salvage value =200000*.25=50000

4.three types of cash flow in capital budgeting

Initail cash flow: cash at the beginning deduct from discount cash inflow to find out NPV

Annual cash flow =this are the Expected cash flow in future Years ,it is Discounted to present value to find out NPV

And Terminal cash flow=Cash flow at the end of the project like Working capital recovered and cash from sale of scrap ,this also discounted at the time NPV caclculation